Tobacco bonds prove unlikely muni market leaders

Amid deteriorating outlook, bonds backed by cigarette revenues rally

By

BenEisen

NEW YORK (MarketWatch) — Opportunistic buyers like hedge funds have supported a rally in tobacco bonds this year, as the embattled corner of the high-yield municipal bond market shrugs off a dominating narrative of decline.

The S&P Municipal Bond Tobacco index is up 13.24% year-to-date, making it the best-performing sector of the market for state and local debt. That beats out the broader Municipal Bond High Yield Index (up 9.75%), and the National AMT-Free Municipal Bond Index (up 5.44%). Gains also compare favorably to other fixed-income sectors like the High Yield Corporate Bond Index (up 5.60%).

Source: S&P Dow Jones Indices

Tobacco bonds have outperformed the high yield index.

Tobacco bonds are backed by payments from cigarette companies like Reynolds American Inc.
US:RAI
and Philip Morris International Inc.
PM, -0.61%
which entered into a master settlement agreement with the U.S. government in 1998. The payments, which are tied to the volume of tobacco shipments, shield cigarette companies from further litigation over the public health-care costs from smoking.

But the cash flows are also sensitive to declining cigarette sales as more Americans kick the habit. The use of cigarettes has dropped more sharply than expected since the settlement, with 18.1% of adults saying they smoke in 2012, compared with 23.5% in 1999, according to the Centers for Disease Control and Prevention.

And tobacco bonds continue to be the butt of bad news. A Reuters report on Tuesday looked at how the growing popularity of e-cigarettes may eat into the revenue of traditional cigarette companies. Some analysts now expect tobacco bonds may begin defaulting within the next decade.

While there are a variety of different tobacco bond types, some of which provide more protections against default than others, the trend across the board is negative: about 20% of the nearly $100 billion in outstanding tobacco bonds already have had to draw on special accounts to cover debt service, according to research firm Municipal Market Advisors.

Munis are rebounding from the worst year in two decades for the asset class, as investors fled state and local government amid fears that the Federal Reserve would withdraw its bond-buying stimulus. Tobacco bonds had it particularly rough in 2013: the index fell 8.8%, but has since recovered those losses.

Philip Morris

Cigarette consumption is on the decline, leading to a broad narrative of decline for tobacco bonds.

“Yield investors seem to be willing to accept significant incremental risk” said J.R. Rieger, global head of fixed income at S&P Dow Jones Indices, in e-mailed comments earlier this month. He noted that as cigarette revenues decline, the risk of default on the bonds becomes more pronounced.

The rally is correlated with a rebound in the high yield muni market, of which tobacco bonds are a prominent part, according to Matt Fabian, managing director at Municipal Market Advisors.

“Tobaccos are the principal high-yield currency in the municipal market: the most liquid, the most commoditized, the most available, and the most purchased,” said Fabian.

One group of buyers has shown particular interest in high yield munis: hedge funds. They have soaked up high-yield debt issued by Puerto Rico in recent months, and that money has spilled over into tobacco bonds as well, according to Fabian. Hedge funds like tobacco debt because they can pick up relatively attractive yields while hedging some of the credit risk by, among other options, shorting the stocks of tobacco companies.

Hedge funds aren’t the only holders. Pimco founder Bill Gross has picked up tobacco bonds for his Total Return Fund
PTTRX, -0.20%
the world’s largest bond fund, according to a report last month from Bloomberg. One of those bonds is the largest tax-exempt holding in his portfolio.

High-yield municipal bonds are becoming easier for retail investors to access as exchange-traded funds like the Market Vectors High Yield Municipal Index ETF
HYD, -0.03%
provide a way into the market.

But the sector isn’t for everyone. Aside from the higher degree of credit risk that comes with junk-rate debt — which, for tobacco bonds is significant — it’s also highly illiquid, which means the debt is tough to trade. Additionally, it’s more sensitive than other parts of the bond market to rising interest rates, notes Heather Loomis, west director of fixed income for JP Morgan Private Bank, who prefers taxable bank loans and high yields.

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